As investors, we always want our investments to generate a healthy return. However, investors often forget that returns stem from two, not one, extremely important factors:
- The business's ability to generate profits.
- The price you pay for one share of those profits.
This idea of price versus returns provides the bedrock for the school of investing known as value investing. In this series, I'll examine a specific business from both a quality and pricing standpoint. Hopefully, in doing so, we can get a better sense of its potential as an investment right now.
Where should we start to find value?
As we all know, the quality of businesses vary widely. A company that has the ability to grow its bottom line faster (or much faster) than the market, especially with any consistency, gives its owner greater value than a stagnant or declining business (duh!). However, many investors also fail to understand that any business becomes a buy at a low enough price. Figuring out this price-to-value equation drives all intelligent investment research.
In order to do so today, I selected several metrics that will evaluate returns, profitability, growth and leverage. These make for some of the most important aspects to consider when researching a potential investment.
- Return on equity divides net income by shareholder's equity, highlighting the return a company generates for its equity base.
- The EBIT margin -- short for Earnings Before Interest and Taxes -- provides a rough measurement of the percent of cash a company keeps from its operations. I prefer using EBIT to other measurements because it focuses more exclusively on the performance of a company's core business. Stripping out interest and taxes makes these figures less susceptible to dubious accounting distortions.
- The EBIT growth rate demonstrates whether a company can expand its business.
- Finally, the debt-to-equity ratio reveals how much leverage a company employs to fund its operations. Some companies have a track record of wisely managing high debt levels, but generally speaking, the lower this figure, the better. I chose to use 5-year averages to help smooth away one-year irregularities that can easily distort regular business results.
Keeping that in mind, let's take a look at Paragon Shipping
Return on Equity (5-Year Avg.)
EBIT Margin (5-Year Avg.)
EBIT Growth (5-Year Avg.)
Total Debt / Equity
Source: Capital IQ, a Standard & Poor's company.
In looking at these companies, Diana Shipping interests me the most, specifically because of its conservative capital structure. Having less debt than its peers should enable the company to weather most economic storms better than those saddled with high-interest payments, a big plus in such a cyclical business.
Paragon Shipping, founded in 2006, capitalized on the surge in global demand for shipping immediately, enabling it to put up such impressive growth rates. While much smaller than some of its rivals -- like Excel Maritime and Diana Shipping -- it has an experienced management team that could continue to grow the business as international trade recovers. Overall, Excel looks solid but not necessarily stronger than other members of its overall peer group. TBS International looks like a shipper to avoid, given its small size, poor returns on equity and margins, and its high debt burden.
How cheap does Paragon look?
To look at pricing, I chose to examine at two important multiples: price to earnings and enterprise value to free cash flow. Similar to a P/E ratio, Enterprise Value (essentially the value of outstanding debt, preferred stock, and common shares combined minus cash) to free cash flow conveys how expensive the entire company is versus the cash it can generate. This gives investors another measurement of cheapness when analyzing a stock. For both metrics, the lower the multiple, the better.
Let's check this performance against the price we'll need to pay to get our hands on some of the company's stock.
Enterprise Value / FCF
P / LTM Diluted EPS Before Extra Items
Source: Capital IQ, a Standard & Poor's company. NM = not meaningful due to negative earnings or free cash flow.
The low expectations for shipping companies really show through here. In looking at the PE ratios, Paragon, Excel, and Diana all appear quite cheap on an absolute basis. However, these bargain prices certainly happened for a reason -- in this case, big drops in share prices due in part to the looming glut of new ships poised to enter markets in the coming years helped lower valuations. The massive capital expenditures that ship purchases require caused Paragon, Diana, and TBS to have negative free cash flow. Excel shows reasonably appealing figures in both categories.
The shipping industry in general benefited massively from the boom in global commerce leading up to the Great Recession. In good times, the businesses can put up impressive results, as seen here. However, their performances also tend to fluctuate wildly depending on the headwinds and tailwinds of the business cycle. This analysis makes the above shippers look like cheap, quality businesses. Although they still have several hurdles to clear before they reach smooth sailing, Paragon, Excel, and Diana all look like potentially attractive risk/reward scenarios. An investment of this kind could take some time to pay off, but could reward those that do so handsomely.
While in my mind Paragon certainly looks like a potential stock for your portfolio, the search doesn't end here. In order to really get to know a company, you need to keep digging. If any of the companies mentioned here today pique your interest, further examining a company's quality of earnings, management track record, or analyst estimates all make for great ways to advance your search. You can also stop by The Motley Fool's CAPS page where our users come to share their ideas and chat about their favorite stocks.
You can also click here to add Paragon and the other stocks mentioned in this article to My Watchlist to stay up to date with all of the latest developments surrounding these or any of your other favorite stocks.
Andrew Tonner owns no positions in any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .